Address by Chairman James E. Newsome of the
U.S. Commodity Futures Trading Commission at the
FOW Derivatives and Risk Expo
New York, New York - May 20, 2003

It is an honor to address you this morning, both those attending the
derivatives expo and those of you with the hedge fund conference. There
are several issues I’d like to discuss this morning that I believe
will be of interest to you. On the managed futures side, we are in the
midst of some significant rule modernizations that will affect commodity
pool operators and commodity trading advisors, as well as other pooled
investment vehicles and institutional investors with an interest in the
futures markets. With regards to derivatives markets, there are a number
of things going on at the CFTC that I want to mention. First, however,
I’d like to take just a moment to describe for you my regulatory
philosophy.

Upon my arrival at the Commission five years ago, I quickly saw that
technology promised to facilitate major changes in the marketplace. I
recognized that these changes held the potential to bring greater
participation, deeper liquidity, and increased efficiency to the
derivatives markets. It was obvious that technological advances could
help to enhance customer service, lower barriers to cross-border
business, and generally improve the availability and usefulness of risk
management tools. Yet it was also readily apparent that the regulatory
structure did not always facilitate such progress. In fact, the
regulatory structure in some cases was stifling innovation and market
efficiency.

For this reason, I aggressively supported the effort to enact the
Commodity Futures Modernization Act, signed into law in December 2000.
This much-needed legislation embodied three key objectives: modernizing
rules affecting trading platforms and market intermediaries, providing
legal certainty for over-the-counter derivatives, and permitting futures
based on single stocks or narrow stock indices. As we have pursued
implementation of those objectives and made changes in how we fulfill our
mission at the CFTC, I have followed a straightforward oversight
philosophy: for the legitimate business activities of those who through
innovation and competition bring to the marketplace greater liquidity,
more useful risk management tools, more efficient pricing, and enhanced
customer service, I want to provide the most flexible and responsive
oversight structure possible.

But there is a second aspect of my oversight philosophy. And that is
that, for those who would attempt fraud or manipulation in these
important markets, I believe in promptly and aggressively exercising our
enforcement authority under the Commodity Exchange Act. My fundamental
belief is that the proper deterrent to wrongdoing is not to issue more
prescriptive or burdensome regulations that adversely affect legitimate
activities but, rather, to bring tough enforcement actions against those
who would try to operate outside the established rules. Those rules
should establish a necessary legal framework without being overly
prescriptive or unnecessarily burdensome. But they must be enforced
vigorously.

The CFTC has been quite active on the enforcement front. I am confident
in the ability of our Enforcement Division to effectively police against
wrongdoing in the marketplace and I know that legitimate market
participants want and need a marketplace free from fraud and
manipulation. For example, when Congress provided helpful legal certainty
in the area of retail foreign exchange fraud, our Enforcement Division
rose to the challenge and in barely two years have conducted numerous
investigations and initiated almost three dozen formal actions, making a
huge dent against this type of abuse.

The Enforcement Division has also been active in the energy trading area.
At the end of last year, the Commission imposed a $5 million civil
monetary penalty against two firms in connection with false reporting and
attempted manipulation. Already this year, a large energy trading firm
has entered into a consent order with the CFTC penalizing it $20 million
for the reporting of false information to energy price reporting
services. And in March, we filed a complaint in federal court in Houston
against another major energy trading company, alleging manipulation of
natural gas prices and the online operation an illegal futures exchange.
The Division is actively engaged in other energy sector investigations,
which may result in further charges being filed or other actions being
taken, as will be announced by the Commission later today.

Let me take a moment here to make two very important points with regard
to these cases. First, and although these cases are quite complex and
require substantial resources to develop, we are striving to conduct our
investigations and to bring the necessary cases just as quickly as
possible so that, in addition to identifying the wrongdoers in the energy
trading sector, we can help to exonerate those who were not involved and
allow the energy and energy derivatives markets to continue with their
work toward restoring the confidence of market participants and the
public.

Second, I do not want there to be any confusion over CFTC intentions when
it brings charges against an entity with regard to illegal futures
contracts. We approach the issues of whether the Commodity Exchange Act
applies to, and whether we have jurisdiction over, any particular
transaction solely on the basis of the economic substance of the
transaction. Thus, where we have brought charges alleging operation of an
unregistered futures exchange that involved the trading of contracts that
may have been labeled or referred to as, quote, “swaps,” it
is because the economic substance of those transactions was that of a
futures contract.

Let me assure you that we are not seeking to expand the scope of our
jurisdiction over transactions, such as true swaps and forwards, that the
Congress has determined -- appropriately so, in my opinion -- to exclude
under the Commodity Exchange Act. In the case of over-the-counter swaps,
for example, such an exclusion was expressly provided by the Commodity
Futures Modernization Act following recommendations from the
President’s Working Group on Financial Markets, and this brought
much-needed legal certainty for counterparties in this important sector
of the risk management marketplace.

Indeed, I believe that such legal certainty is critically important for
the efficient and reliable operation of markets generally, but perhaps
particularly important for many derivatives markets. If the
enforceability of contracts is in doubt among counterparties or if laws,
regulations, or even an agency’s enforcement policies are unclear,
then rational market participants must factor that uncertainty into their
decisions and this, in turn, can result in unnecessary added costs,
missed opportunities, inefficient results, and misallocated resources. I
believe that is why Congress took care to provide additional legal
certainty in various areas through the Commodity Futures Modernization
Act and I am committed to adhering to that path as we move forward.
Oversight agencies, such as the CFTC, can meaningfully reduce doubt and
uncertainty in a variety of ways, and sometimes even beyond their own
regulations and policies by suggesting or supporting statutory changes to
the Congress.

For example, certain amendments to the bankruptcy code have been proposed
that could help to alleviate counterparty credit risk concerns in certain
derivatives markets. These concerns appear to be a serious constraint on
trading activity, and thus on liquidity and risk management
opportunities, in various markets, but particularly energy derivatives.
The proposed amendments would help to ensure the enforceability of
acceleration and termination provisions, netting clauses, and other
contractual safeguards in the event of one counterparty’s
insolvency. In previous years, my fellow members of the President’s
Working Group on Financial Markets and I have written to the Congress to
voice our strong support for legislative proposals that would effect such
amendments. Most recently, following a joint conference on potential
solutions to credit risk problems in the energy markets, Chairman Pat
Wood of the Federal Energy Regulatory Commission and I wrote to the
Congress to express our support for such changes and to highlight the
benefits that might quickly accrue from providing potential market
participants with a greater degree of certainty that the key protections
which they carefully negotiate into their transaction agreements will be
honored and enforceable should a problem ever arise. It is my
understanding that recently on Capital Hill a stand-alone measure to
address these concerns has been introduced, an initiative I would
support.

Of course, it is possible for the goal of legal certainty for markets and
market participants to be harmed as well as helped by governmental
efforts, particularly if proposed solutions to perceived problems in the
marketplace are pursued without adequate discussion, consideration, and
debate. For example, I believe that the Commodity Futures Modernization
Act reflected careful consideration and that its passage was preceded by
informative discussions with and among the relevant financial regulators,
in particular the members of the President’s Working Group on
Financial Markets. I would therefore hope that any legislative amendments
to the CFMA, particularly those that might impact legal certainty, would
be pursued only in close consultation with the PWG. As Chairman Greenspan
recently noted, the derivatives markets can be credited with
strengthening the financial system and making it more resilient to
economic shocks, which ultimately benefits the economy as a whole. The
importance of these markets should not be overlooked nor should the fact
that effective control mechanisms within the markets themselves have made
defaults and other problems very rare.

I’d like to mention a few of the CFTC’s current efforts that
may be of interest to many of you here today. The public comment period
recently closed on a variety of proposed rule changes that would
modernize our oversight in the managed futures area. My fellow
commissioners and I are always grateful for the time and attention that
market participants devote to providing us with invaluable feedback and
suggestions when we solicit public comment on pending matters. This time
was no different, as we received a large number of thoughtful and
insightful comments.

Some of the rule changes would provide operational flexibility for
commodity pool operators, such as proposals to reduce duplicative
reporting requirements among master/feeder funds, to permit electronic
distribution of account statements, and to provide alternative means of
reporting past performance. For pool operators and commodity trading
advisors that limit participation to sophisticated persons, the CFTC has
for some time provided a more flexible set of requirements but we
recently proposed a new exemption from registration for those that limit
participation to highly sophisticated persons or that restrict futures
activity to a de minimus level. I am hopeful that, in addition to
modernizing regulations for entities that currently use the futures
markets, the final rules in this area may increase interest in the
futures market by entities that have not used them before, which can
ultimately benefit all market participants with greater market liquidity.

In a similar vein, we proposed to modernize the exemption for certain
otherwise-regulated entities -- such as banks, mutual funds, and
insurance companies -- that wish to use the futures markets. Currently,
these entities are only permitted to engage in a very limited amount of
activity before they are required to register, which could subject them
to unnecessary duplicative oversight. Accordingly, we proposed to
completely lift that restriction on trading activity by appropriately
otherwise-regulated institutions. The numerous comments we received were
overwhelmingly in favor of both proposals and also contained some helpful
technical suggestions that our staff are reviewing. It is my hope that we
will be able to finalize our rule modernizations in this area very soon.

We are also in the midst of various other modernization efforts,
including moving to risk-based audits of market intermediaries,
developing an appropriate oversight framework for futures clearinghouses,
and providing clarity and greater operational flexibility for futures
commission merchants in areas such as bunched orders. Comments on the
proposals in these areas have been enormously helpful and we are actively
evaluating how to move forward on these issues. My desire to pursue
continuous improvement in our oversight is based on my firm belief that
prescriptive regulations and inflexible prohibitions which ignore the
unique risk management needs of different types of market users can
impose substantial costs on market participants without achieving any
increase in protections or reduction in risks. Instead, oversight that
provides the flexibility needed for legitimate innovations in risk
management, combined with workable safeguards, can better protect against
systemic and individualized problems.

Our attention at the CFTC these days is not focused strictly on our own
rulemakings. We are watching with great interest the various developments
in the business structure of the futures markets, particularly new
relationships and arrangements that have been announced or proposed. It
is my view that such developments directly reflect a healthy competitive
environment. The continuing and strong growth in derivatives trading
activity across the board certainly seems to confirm that. That growth
reflects increasingly widespread recognition of the benefits of
derivatives-based risk management by businesses and investors that today
represent virtually every sector of the economy.

I believe that true economic competition is a dynamic process that
results in an ever-changing landscape as new entrants bring new products
and ways of doing business to the market and existing competitors
promptly respond with vigorous innovations of their own. I must add,
however, that market access does not necessarily mean market success. It
is our goal as a regulator to provide a level regulatory playing field so
that new competitors and existing competitors alike have an opportunity
to compete. Ultimately, it is the market users who benefit most by this
process. Some have expressed concern about recent reports of new competitors
entering the marketplace, both domestically and from abroad. Let me say in
this regard that it is my intention, as in the past, to deal with every
existing and potential market participant -- whether exchange,
clearinghouse, or FCM and whether domestic or foreign -- on a consistent
basis in every respect. Let me also state my intention to approach each
new circumstance or proposal with an open mind and a willingness to
consider ways in which the CFTC can remove any artificial barriers to
competition which may exist -- particularly outdated regulations that
might constrain such things as product innovation, capital efficiency, or
cross-border business. But I should also say that I may exercise a bit of
caution about attempting to impose a premature regulatory solution that
might later prove to be inefficient or ineffective.

Ten years from now, I believe that we will all look back on this period
in the development of the derivatives markets, on- and off-exchange, as
an incredibly exciting period in which monumental changes took place to
make derivatives-based risk management more efficient, more accessible,
and a more vital part of U.S. business than ever before. And, as
I’ve said before, that outcome is most likely to come about through
the efforts of market participants themselves. The current debate over
the optimal structure of the marketplace and its key institutions,
particularly with respect to clearing and margin issues which will be
discussed quite a bit over the next two day, is a good example of a
situation that, I believe, can best be resolved primarily through
business decisions rather than regulatory mandates. Certainly, key
business decisions are currently being made in this marketplace.
That’s why I’m pleased to see the dialogue on these issues
continue in forums such as these conferences and I look forward to the
discussions.